The Alchemists: Three Central Bankers and a World on Fire by Neil Irwin Page A
Authors: Neil Irwin
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to sell all over the world that they had little interest in knowing too much about what they were getting. The global investors buying the securities did so without necessarily understanding all the gory details of who the borrowers were and what their capacity to repay might be. The gold seal of an AAA rating was enough.
The giant banks were the great intermediaries that made possible an apparent explosion of wealth. There were, by 2007, $202 trillion in financial assets on earth , 3.6 times the annual economic output of everyone on the planet; in 1990, the ratio was 2.6. That represents an extra $42 trillion in paper wealth over what would have existed had the ratio stayed constant. Global megabanks, hedge funds, insurance companies, and countless other financial firms were links in the chain that connected borrowers taking on ever larger amounts of debt with the global savings glut. And in Jackson Hole in 2005, almost no one seemed to understand just how weak that link was.
But what
did
they understand? What did central bankers know about what was out of whack in the world economy? And when did they know it?
On both sides of the Atlantic, central bankers had been fretting about the run-up in housing prices, even if they weren’t quite sure what to do about it. Without solid answers, they resorted to just trying to describe, with gentle euphemism, what was occurring in the property markets. There were “ elements of buoyancy ” in Spanish and Irish housing markets, as Jean-Claude Trichet put it in May 2007. Greenspan had conceded two years earlier not that a bubble was building, but that there was “froth”—a number of small bubbles in certain markets. “ It’s pretty clear there is an unsustainable underlying pattern ,” he told the Economic Club of New York. Three weeks before the 2005 Jackson Hole conference, Mervyn King was sufficiently worried about a British housing bubble that he tried to raise interest rates in order to slow down the housing market. Unusually for a central-bank governor, he was outvoted by Britain’s interest-rate-setting committee. The joke that went around London financial circles was that as a fan of the perpetually mediocre Aston Villa football club, King felt comfortable losing.
The debate that went on behind closed doors at the Federal Reserve in 2005 reveals how challenging it was for the central bankers to convert their sense that something was wrong in housing into concrete policy. When the Fed’s Federal Open Market Committee met privately around the grand mahogany table overlooking Constitution Avenue in Washington to set interest rate policy for the United States, those concerns were sometimes aired—but rarely with a sense of urgency about finding policies that might alleviate them.
“ Hardly a day goes by without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy,” said a dismissive Richard Peach, an economist at the Federal Reserve Bank of New York, in a confidential presentation to the FOMC on June 29, 2005. The rapid gains in the housing market, he said, “could be the result of solid fundamentals underlying the housing market”: low interest rates, strong productivity, peak earning of the baby boom generation, and rising incomes, particularly among the affluent.
The same day, the committee heard a presentation on how a housing decline might affect the financial system. “ Neither borrowers nor lenders appear particularly shaky ,” economist Andreas Lehnert told Fed leaders as he gave an analysis of exposure to risky mortgage lending by U.S. banks and other institutions. “Perhaps it would be best simply to venture the judgment that the national mortgage system might bend, but will likely not break, in the face of a large drop in house prices.”
Fed policymakers were attuned to the possibility that housing prices could decline, perhaps
The giant banks were the great intermediaries that made possible an apparent explosion of wealth. There were, by 2007, $202 trillion in financial assets on earth , 3.6 times the annual economic output of everyone on the planet; in 1990, the ratio was 2.6. That represents an extra $42 trillion in paper wealth over what would have existed had the ratio stayed constant. Global megabanks, hedge funds, insurance companies, and countless other financial firms were links in the chain that connected borrowers taking on ever larger amounts of debt with the global savings glut. And in Jackson Hole in 2005, almost no one seemed to understand just how weak that link was.
But what
did
they understand? What did central bankers know about what was out of whack in the world economy? And when did they know it?
On both sides of the Atlantic, central bankers had been fretting about the run-up in housing prices, even if they weren’t quite sure what to do about it. Without solid answers, they resorted to just trying to describe, with gentle euphemism, what was occurring in the property markets. There were “ elements of buoyancy ” in Spanish and Irish housing markets, as Jean-Claude Trichet put it in May 2007. Greenspan had conceded two years earlier not that a bubble was building, but that there was “froth”—a number of small bubbles in certain markets. “ It’s pretty clear there is an unsustainable underlying pattern ,” he told the Economic Club of New York. Three weeks before the 2005 Jackson Hole conference, Mervyn King was sufficiently worried about a British housing bubble that he tried to raise interest rates in order to slow down the housing market. Unusually for a central-bank governor, he was outvoted by Britain’s interest-rate-setting committee. The joke that went around London financial circles was that as a fan of the perpetually mediocre Aston Villa football club, King felt comfortable losing.
The debate that went on behind closed doors at the Federal Reserve in 2005 reveals how challenging it was for the central bankers to convert their sense that something was wrong in housing into concrete policy. When the Fed’s Federal Open Market Committee met privately around the grand mahogany table overlooking Constitution Avenue in Washington to set interest rate policy for the United States, those concerns were sometimes aired—but rarely with a sense of urgency about finding policies that might alleviate them.
“ Hardly a day goes by without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy,” said a dismissive Richard Peach, an economist at the Federal Reserve Bank of New York, in a confidential presentation to the FOMC on June 29, 2005. The rapid gains in the housing market, he said, “could be the result of solid fundamentals underlying the housing market”: low interest rates, strong productivity, peak earning of the baby boom generation, and rising incomes, particularly among the affluent.
The same day, the committee heard a presentation on how a housing decline might affect the financial system. “ Neither borrowers nor lenders appear particularly shaky ,” economist Andreas Lehnert told Fed leaders as he gave an analysis of exposure to risky mortgage lending by U.S. banks and other institutions. “Perhaps it would be best simply to venture the judgment that the national mortgage system might bend, but will likely not break, in the face of a large drop in house prices.”
Fed policymakers were attuned to the possibility that housing prices could decline, perhaps
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